Mark LaMonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Shani Jayamanne: So today is a listener requested episode, and it’s on small caps. And this was submitted by Chris, who gave us an incredibly detailed list of what he wanted to know – so that makes our job a lot easier.

LaMonica: So Chris wants to know – should we have an allocation to small caps, how to find a good business, what are the risks of small caps, what role can they play in the portfolio and how much should be allocated to small caps, are there differences between Aussie small caps and the rest of the world, and if we’re taking the ETF or managed fund route, should we opt for active or passive.

Jayamanne: That is quite an exhaustive list.

LaMonica: It is. But we like that.

Jayamanne: So let’s start right at the beginning, and we’ll start by defining what a small cap is.

And usually the definition is the easiest bit of the podcast, but it really isn’t that easy. Small caps is short for small capitalisation, and refers to the size of the company’s market capitalisation when they are listed.

LaMonica: And stocksare categorised as micro-cap, small cap, mid cap, and large cap.

Small caps have a different definition of small, depending on who you ask. If you ask Investopedia, they believe that they are between $300 million and $2 billion. If you ask Morningstar, Small Cap can be defined as the stocks in the bottom 10% of the capitalisation of an equity market, or for tighter guidance, stocks under 800 million in market cap in the US market – because context is important. If you ask Nasdaq, they believe it’s companies with a value less than $1 billion. It really depends on who you ask.

Jayamanne: That wasn’t helpful at all.

LaMonica: No, it wasn’t.

Jayamanne: But let’s just meet in the middle and say that it’s a company with a market cap between 250 million and 1 billion dollars as a general guide. These are stocks that might not be household names – yet, and generally, investors are attracted to them because of their growth potential.

LaMonica: And we love clean definitions but it is also worth saying that it doesn’t really matter. What we are really talking about is small companies here. A couple million dollars in market capitalisation doesn’t really make one difference or another. A small company is either one that has a product or service that is just emerging and has so far failed to gain widespread acceptance, a company that is serving a very limited market or a company that only has a very limited product range. It can also be a company that investors are very sceptical about because after all we are talking about market capitalisation which means if a company is trading at a very low valuation it could qualify as a small cap as well. And none of these conditions are mutually exclusive. A small company could meet several or all of these conditions.

And we will get back to the implications of these characteristics in a bit but they are very important when it comes to investing in small caps.

Jayamanne: How to find a good business is a little more complicated. But we do need to state that the way you find a great small business is the same as you find a great large business. You are looking for companies that are going to grow cash flows into the future. You are looking for companies that are trading at a reasonable valuation level based on those future prospects. And you are looking for companies that have a sustainable competitive advantage to hold competitors at bay because intense competition can crush investing outcomes.

LaMonica: Yet even if the process is the same it can be a lot harder with small cap shares. They will disclose the same information that is legally required as apublicly traded company. But at the same time there is a lot less scrutiny from professional investors and the media. For example, you’re much more likely to hear about Westpac on the nightly news than you are about some Aussie small caps like Appen or Tyro Payments.

Jayamanne: Although it is a bit more difficult to get the full picture, it’s not impossible to analyse small cap companies and make an educated investment. And many people think that this is an advantage because away from the limelight it gives every investor a chance to level the playing field with well resourced professional investors. But this opportunity comes with huge challenges which we will get into in a bit. But foundationally as we said, the process would be very similar to what we outlined in our Swipe Right for Shares series. We’ll link that in the episode notes.

LaMonica: Now – the question is – whether you SHOULD invest in small caps.

Jayamanne: We talk a lot on the podcast about asset allocation. When we speak about asset allocation, we’re speaking about asset classes at a high level – for example, Australian equities, international equities and fixed income and bonds.

LaMonica: Within Australian and international equities, there’s differing risk and return profiles – it can be through market capitalisation – small cap has a different risk and return profile to large caps.With bonds, there’s treasury and junk bonds.

Jayamanne: The spectrum of risk differs from asset class to asset class, but it also differs within asset classes. It is here that valuation can help with picking and choosing direct equity investments. The key to this, however, is to ensure that you allow for an adequate margin of safety. With small caps, the uncertainty of their earnings are increased.

LaMonica: We’ll speak about what we mean by this in a second, but let’s first address what we mean by margin of safety.

Jayamanne: When we’re speaking about margin of safety, we’re speaking about the difference between the market price and the intrinsic value of the investment. For example, if a large cap stock is trading at $14, but we value it at $17, the margin of safety is $3. If a small cap stock was trading at $14, and it was valued at $17, you would think twice before purchasing the stock, as the uncertainty of future earnings is much higher than the large cap stock.

LaMonica: And the reason we are talking about margin of safety here is because of the inherent characteristics of small caps. These are the ones that we talked about before – a company offering a product or service that has yet to gain traction, a company that is serving a very limited market or a company that only has a very limited product range. And of course a company that investors are very sceptical about.

Jayamanne: All of this equals business risk. Perhaps the product will catch-on and perhaps it won’t. That is very different risk profile than a company that already has established products. Perhaps the company will grow from a very limited market to a global audience. That is very different than a company that is already global. Perhaps a single product or service range will expand dramatically to a suite of offerings. Perhaps it won’t. That is very different than a company with a diversified range of offerings.

LaMonica: The other thing that is important to note is that as small companies many of these companies don’t have the financial resources to ride out company specific and macro issues with the economy. If things go south economically they won’t have the same access to capital markets and banks to get more money as a large established company will.

Jayamanne: If you only serve one country than an economic slowdown in that specific country will impact you more than a company that is selling products globally. If you have one product or service and something goes wrongit can mean the company goes out of business. If you have multiple products and services you can survive that.

LaMonica: And as we said the way you approach those risks is by having a larger margin of safety. The way you approach individual company risk is to widely diversify. So in summary here we have companies that have less scrutiny with less press and analyst coverage and we have companies that are inherently more risky just because they are small companies. This has two very important implications for the way we want to access these investments and who they are right for.

Jayamanne: Lets start with the way you access small caps. If you are going to pick individual shares you need to consider if you have enough of an investing edge to be able to pick these stocks. We’ve spoken about investing edges before, but they are important to identify to understand whether you should be picking direct equities.

LaMonica: This is especially true in the case of small cap stocks. Yes there may be some inefficiencies in this less scrutinised part of the market but the question is if investors can take advantage of that presumed inefficiency.Our Active Passive Barometer report has shown that this may be where an active manager can add value. Active managers perform well in large and broad markets that aren’t well covered. This is the small cap market. The issue however, that our analysts note, is that in theory, although the small cap markets are inefficient and provide a good hunting ground for active managers to generate alpha, this just hasn’t happened. Over the past 10 years to 30 June 2022, the results of active managers in this space have been underwhelming. This is backed by research conducted by S&P on international small cap markets as well – passive strategies have worked out better in the long term.

Jayamanne: We’ll speak a little later onwhat our analysts believe is a good alternative.

But for now we are going to cover who small caps may suit.There are some specific additional risks that should be considered that we haven’t spoken about.

LaMonica: The first is liquidity. Because it is a small cap, logically, that means that there’s not as much trade volume coming in and out of the stock. The first hurdle is buying the stock, as the volume that you want to acquire may not be available to you immediately. The second hurdle is selling the stock, because there may not be enough demand from buyers to allow you to dispose of the investment. Although historical trading volumes are not indicative of what will happen in the future, looking at this measure before you purchase your stock will give you some indication about whether it will be difficult to sell in the future. This means that small caps may not suit investors that foresee that they will need to access cash quickly from their investments.

What this lack of liquidity means is that there’s also volatility. Any decently sized trades can move the share price up or down. Smaller investors or a large investor interested in a share can move the market significantly.

Jayamanne: I see this all the time with some of the small cap stocks that I hold –The lack of liquidity in trading volumes means that every time I log on to Morningstar Investor, we have this widget on the home page – gainers and losers – so the top gainers and the biggest losers that day from your portfolio – they always make an appearance at the top of either of those lists. It’s not that there’s material information being released every second day that moves the share price, it’s simply a few people selling in or out of the investment that’s causing the share price to jump or fall.

LaMonica: Volatility is not a friend to any investor that’s close to achieving their goals, or is drawing down on capital. This can often mean locking in losses, or being forced to sell out of the investment at an unfavourable price. Volatility can also lead to poor investor behaviour because people get spooked. You need to ask yourself if you can withstand this volatility without resorting to behaviour that will ultimately lead to poor outcomes.

Jayamanne: This brings me to dividends. Those that are drawing income from their investments would probably avoid small caps. Although some small cap companies are mature, the majority are hoping to grow their business and operations.

LaMonica: This often means that capital allocation focuses on internal or external growth opportunities, instead of distributing the capital as dividends to shareholders. Most small cap investments would not suit income oriented investors that are looking for sustainable and consistent dividends.

Jayamanne: The second risk is the opportunity cost of the investment. When you are investing, you are making a conscious decision about where to allocate finite capital. Choosing to invest in a small cap stock means that you are forgoing an investment with more certain earnings. The reason that investors choose to invest in small cap stocks is the prospect for multiples of growth, which may or may not eventuate. When it does eventuate, the growth will be more accelerated and larger than an established, mature company. If it doesn’t eventuate, you’ve taken a risk on a company’s prospects instead of investing in an established mature company with a slower, but more solid growth trajectory. The upside is, though, because they are often not as well covered, there is more opportunity to find quality companies at lower prices.

LaMonica: This brings us to Chris’ next question, which is what role can they play in an investors’ portfolio?

When you look at the risks that we’ve mentioned – volatility, lack of dividends, liquidity, and risk that the company might not perform or even last, it is more of a list of what role they can’t play in an investor’s portfolio than who they suit.

Jayamanne: At the end of the day, we need to step back from looking at small caps as investments and start to study them as businesses. If you are a business owner that has a small business, would you expect growth to occur overnight? What about in a year?

LaMonica: Ultimately, with small caps, it is a question of moderation and time. As attractive as the potential for growth is with small cap stocks you need to consider whether you have a long enough time horizon to allow the potential for organic growth to play out, as well as the, hopefully depressed valuations that you invested in to rise as markets recognise the future earnings potential.

Jayamanne: A study by Standard and Poors looked at the periods in which small caps paid off for investors for the risk that they took on. The study looked at 20 year total returns between the S&P Developed Ex-US Large Midcap, and the S&P Developed Ex-US Small Cap. Small caps have higher risk over three to five year periods, but over a 10-20 year period onwards, small caps outperformed mid and large caps.

LaMonica: For investors with less than a ten year time horizon to achieve their goal, small caps might not be the right subclass. For those with more than ten years, consider what you are trying to achieve with the investment.

Jayamanne: Is it a quick hit of capital gains? The likelihood of this happening is not very high. Businesses do not evolve overnight, as we spoke about. And if you are investing in a business because you expect it to go up overnight, that is most likely a speculative trade instead of investing.

LaMonica: Do you believe that the business has strong growth potential in a growing industry with a growing market? Does the business have savvy management making smart capital allocation decisions to foster growth?

Jayamanne: This is where the moderation side of the equation comes in. Within your domestic or international exposure, ensure that you are using small caps as a supplement to the allocation to that asset class, instead of the main show.

LaMonica: There is also an argument that small caps have no place in most people’s portfolios. This theory basically suggests that you are able to adjust your portfolio in other ways to change the risk and return profile, without the volatility, liquidity and income issues. A simple example would be to increase the Australian equities portion of your portfolio through mid and large cap and reduce the fixed income portion of your portfolio.

Jayamanne: This argument works in theory, but is not a direct replacement for small caps in your portfolio. It does notmimic the same risk and return profile, and it does not take into account the typically lower valuations of small caps, the growth potential.

Alright – let’s move on to the inclusion of Aussie small caps vs. international small caps.

LaMonica: Traditionally, international small caps have been considered an untamed beast where the risk was not really been worth the reward for many investors. International small caps can offer broader exposure and diversification for your portfolio, as often, investing outside of Australia and mid and large cap subclasses will give you access to geographies, sectors and markets that you would not traditionally have exposure to. They also have lower correlation to other asset classes.

Jayamanne: So great for diversification and broad exposure for your portfolio.

We’ve covered Chris’ last question throughout this podcast. When it’s a choice between active and passive, passive has outperformed in the past, and it is our analysts’ expectation that passive will continue to outperform active counterparts in this subclass.

LaMonica: We have one gold medallist small cap ETF, and that is Vanguard MSCI International Smaller Companies ETF with the ticker symbol VISM. The analyst notes that it has an unbeatable cost value proposition over active and passive peers alike, and it has highly efficient access to the developed market small cap stocks via an impressivediversified index.

Jayamanne: The analyst goes on to say that the global small cap market is incredibly broad. It is rife with many risks that foster inefficiencies, and has led to a wide range of outcomes. Again, he mentions that this would be a hot bed for opportunities for active managers, but it just hasn’t worked out that way.

LaMonica: They say that the issue is scale, and not skill.Most active managers just don’t have the scale to deploy cross-sectional analysis that weighs up both opportunities and threats at the global level across the different sectors and countries, putting them on the back foot compared to passives that are just all inclusive.

Jayamanne: This is an important point to note, and goes back to whether direct investments in small caps, especially international small caps, is achievable for an individual investor.

LaMonica: The answer may be that it is achievable, but it isn’t worth it. It would be a full time job to actively manage and research a portfolio filled with international small cap stocks. This may be where a collective investment vehicle like an ETF or fund can help out.

Jayamanne: Australia might be a little bit of a different story. Since Australia’s listed investment market is very small, if we look at market capitalisation, you can consider stocks 101-300 as small cap. This is exactly what the index S&P/ASX Small Ordinaries covers, and it accounts for 12% of the market here in Australia. Unlike the US, some of these companies are household names already, such as Kogan, or Lovisa, or Nick Scali.

LaMonica: For Aussie investors that prefer to invest in direct equities, the landscape is narrow in Australia, and scale is not as much of an issue for finding opportunities and maintaining a small cap portfolio.

Jayamanne: One of those household names that is currently attractive is Kogan.

Kogan is currently trading at five stars, with a market cap under 400 million. We’ve spoken about Kogan a few times, so we’ll pick a new one to delve into.

LaMonica: Investors may not have heard of this one – AVITA medical. AVITA is currently trading at a 51% discount as the 21s of Feb, making it a five star stock. AVITA medical is a company that specialises in bur treatments. Our analyst believes that Avita will be successful based on the product’s clinical performance, ease of use and relative price point.

Jayamanne: One particular product seems to be leading the charge for AVITA – their RECELL system that has been used since the Bali bombings in 2002. It creates a spray on skin within 30 minutes from a skin sample, typically less than 5% of the size required in a graft. It has been clinically demonstrated to heal the burn site as effectively as a skin graft without the need for a huge wound from a donor site that’s required from a graft.

LaMonica: It's had limited commercial success so far because it entered the market as an investigational device, and this limited the take up for the product. RECELL relaunched in the US in late 2018 and it’s approved for treating 2nd and 3rd degree burns in paediatric and adult patients. RECELL has a price of $7,500 USD versus $17,000 to $20,000 for a skin graft – it also has benefits of shorter length of stay and fewer additional procedures. Because of this promising outlook, Avita is estimated by our analysts to ramp up to a 34% share of the market, or 4,800 patients per year by fiscal 2026. It’s likely to be loss-making until 2025.

Jayamanne: Of course, as a small cap that is relying mainly on the success of this one product, AVITA has a high uncertainty rating. There’s obviously risk with uptake and the success of the roll out. The company is still in early stages for the commercial roll out, so it’s difficult to forecast success and therefore, the valuation has a high uncertainty.

LaMonica: So all in all, small caps may have a role to play in your portfolio if you have a long time horizon that is not impacted by short term illiquidity and volatility. It can offer broad exposure and diversification in your portfolio, but it may be worth considering investing in a passive ETF for international small cap exposure, or moderating your exposure for domestic small caps if you are investing directly.